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Wall Street likes to downplay the idea of a stock market crash and the risks associated with a significant fall in share prices, but the truth is that bear markets and sharp price declines can and do happen with some frequency.
As investors, we cannot afford to blithely ignore the possibility and potential for a negative market event to damage our long-term plans. That's when investors see their net worth cut by half or more - which has happened twice in just the last decade.
We need to be aware of when the risks of a big decline are rising and take measures to protect our net worth.
This is such a time.
Stock Market Crash Risks are On the Rise
Although the stock market does not appear to many analysts to be severely overvalued, there are very real risks to the economy and the market.
For example, if no compromise is reached to avert the fiscal cliff, the Congressional Budget Office estimates that the combination of spending cuts and new taxes could shave as much as four points off gross domestic product growth and push us back into recession. Plus, taxes on dividends and capital gains will increase sharply and could well make stocks less attractive to investors.
MIT Finance Professor and corporate valuation expert Aswath Damodaran recently did a study of the potential impact of the new tax structure. He found that the increased taxation reduced the value of stocks by 7% to 30% depending on the yield of the individual security. The higher the yield, the more of a haircut to the value of the company.
Even if the president and Congress are able to reach a compromise that avoids the dreaded cliff there are still large potential negatives for the stock market. Most investors value stock on earnings and potential growth, but the weak U.S. economy is limiting growth opportunities.
As third-quarter earnings reports have shown us the economy is not strong enough for companies to improve their top or bottom line. Most of the S&P 500 companies have reported and average earnings are down more than 2%, with revenue down by almost 4% on a year-over-year basis. It has been the weakest earnings quarter since 2009.
The stock market also has substantial headline risk right now.
We have seen sharp selloffs caused by news out of Europe the past few years and it is highly liley we will again as we head into 2013. We'll see more talk of defaults and civil unrest out of Greece before too much time passes. Spain and Italy are still experiencing sell offs and even the German economy is showing weakness.
The situation in the Mideast is still very unstable as the region teeters between Arab Spring and global nightmare. Headlines from any of these regions could easily cause selling panics and extended price declines in U.S. stock prices.
One of the biggest reasons we may well see a bear market raise its head in the next year is the fact that we are simply due. Declines of 20% or more in the market usually occur every three-and-a-half years or so.
We have not had one since the market bottom in 2009. We saw decline of more than 10% on several occasions and a 17% drop in the late summer and early fall of 2011. The market has better than doubled off the 2009 bottoms without a meaningful and lasting sell off.
A 20% drop now could take us to an S&P level of around 1,180 or a Dow Jones Industrial Average price of 10,300 or lower.
Now it seems that the economic and market specific catalysts are falling into place for a stock market crash, and risk is higher than any time since the last significant market top in 2007.